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Emerging from the merger

By Fiona Rotherham

Saturday 1st June 2002

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Baycorp Advantage is on track to deliver promised synergy benefits and earnings growth following its $1.9 billion transtasman merger, yet the market has caned the company's share price. Fiona Rotherham investigates and finds a sound merger behind a lousy stock valuation

There's an anecdote Keith McLaughlin, Baycorp Advantage chief executive, likes to tell. In it, he's on a plane flying to New Zealand from Sydney accompanied by six of his staff. Some of those staff are from his former family business, debt collector turned financial data wizard Baycorp; others are from its Australian rival Data Advantage. Despite it being only six months since the merger of the two companies to form Data Advantage, McLaughlin says he's hard pressed to remember which of his co-travellers come from which company. Even the accents don't help - at least one Australian had previously worked for Baycorp. McLaughlin says the staff all spoke and acted as if they had been part of the new company forever.

Of course, McLaughlin's anecdote tells analysts and shareholders just what he wants them to hear - that the integration of the two companies has gone virtually without a hitch. McLaughlin also says, and analysts don't disagree, that Baycorp Advantage looks on track to deliver the promised $A15 million ($18 million) in synergy benefits over the next three years (two-thirds from cost savings and one-third from higher revenue).

If McLaughlin is right, why has the share price gone down from $7.45, when the newly merged company established its primary listing in Australia in December 2001, to as low as $4.70 in early May? That's a whopping 37% drop. When, if at all, can shareholders expect to see the synergy benefits from the merged entity seep into the share price?

The answer is "not yet", but not because the merger isn't a good one.

Beating the numbers

It's worth putting the merger into perspective. International research shows between 60% and 80% of all mergers and acquisitions are financial failures, in terms of their ability to deliver the expected profit increases. A study by American Mark Sirower, summarised in his book The Synergy Trap, found that of 168 deals analysed, roughly two-thirds actually destroyed value for shareholders.

Take AOL Time Warner. Two years after the formation of the world's largest internet and media company, it recently announced it was writing off $US54 billion - that's about equivalent to New Zealand's gross national product - to reflect the decline in value of its $US106.2 billion purchase of Time Warner in 2000.

Baycorp's attempt could potentially have been doubly doomed as it involved a transtasman merger, and New Zealand companies haven't got a great history in Australia. It is still too early to say definitively whether Baycorp Advantage's merger has bucked the trend - experts say it normally takes at least a couple of years before the real financial situation of the joint company becomes apparent. Look at Air New Zealand.

But the signs are good. So far it has gone remarkably well, according to the company and analysts covering the stock. There hasn't been a sloughing of second tier staff (a sure sign of post-merger problems) - in fact, Baycorp has increased staff numbers in New Zealand, where payroll costs are lower. And as McLaughlin says, culture fit issues (one of the major causes of failed mergers and acquisitions) seem to have been anticipated and dealt with. The company has retained both chief executives.

Baycorp Advantage's first result since the merger, for the half-year to the end of December 2001, showed profit falling 69% to $A1.63 million ($NZ1.9 million). But restructuring costs of $A4.8 million (total merger costs are estimated at $A14 million and are spread over the first two years) and higher amortisation charges to write off goodwill masked the underlying performance, says JB Were analyst Marguerite Ricketts. Double-digit revenue growth was achieved across all of the company's newly defined business units, she said in an April report.

The result included six months of Data Advantage results and only 18 days of the former Baycorp. However, the company also produced pro forma accounts showing what the combined business would have done had the merger taken place at the start of the half-year. In these results, EBITDA (earnings before interest, tax, depreciation and amortisation) increased by 17% to $A24.9 million ($30.49 million). McLaughlin says the company is on track to deliver similar growth in future, as the second half result is always better than the first. Ricketts is also positive about the company's long-term strategic position, expecting core business earnings growth of 20% (that's not including any synergy benefits) to continue for the next three to five years. The key issues still to be dealt with are the integration of IT platforms and managing cross-border relationships within the company, she says.

One stop debt shop

McLaughlin has proved himself to be one of the smarter operators of the New Zealand business scene. There's no reason he can't do it again. McLaughlin's father Ray founded Baycorp in 1956, as a small Lower Hutt-based debt collection agency. Keith joined the family business aged 18, when debt collection meant knocking on doors and lugging away the household fridge.

After listing on the stock exchange in 1986, the company suffered in the share market crash and had to write off a failed expansion into Australia.

It made a steady recovery during the 1990s, largely due to clever and early use of software, database and internet technology. By the late 1990s Baycorp had progressively picked off smaller businesses to become New Zealand's dominant credit reporting agency and debt collector.

Data Advantage was Australia's largest consumer and commercial information services company. Its software allowed companies considering credit applications from people to assess how much risk was attached to them paying it back. Originally formed as a mutual organisation in 1967, it demutualised in 1998 before listing on the Australian Stock Exchange.

Both Baycorp and Data Advantage have enjoyed earnings growth rates of above 20% each year over the past five years. But how to keep growing? Mergers and acquisitions have been the dominant growth strategy for businesses since the 1960s. The trend is accelerating, with worldwide mergers and acquisitions valued at $US3.4 trillion in 1999, up from $US2.6 trillion the year before. However most don't live up to expectations and many fail altogether.

The cloud

Data Advantage chairman Roseanne Meo and McLaughlin don't admit to any merger problems, although McLaughlin does say there is a lot to do in a short period of time, particularly in the information technology area. David Grafton, former Data Advantage chief executive, now executive director of the new company, is less reticent. He says there have been some technology issues "larger in scale and complexity than we had imagined". The company is mid-way through a detailed technology review.

The expected synergy benefits of $A15 million include only a small amount ($A2.9 million) of the benefits that may be gained from a single technology platform. The main reason the synergy benefits are spread over three years is because Data Advantage outsourced most of its technology infrastructure to another company, and the contract doesn't expire until 2004. Terminating the contract early would incur hefty fees.

The merged company is run on business unit lines, rather than on a geographical basis. While Grafton says this was the right decision to take, the reality has proved harder than either he or McLaughlin first thought. "The sheer added complexity means you often need to be in two places at one time. Technology allows you to communicate by voice or video but sometimes there is no substitute for actually being there."

He's confident both problems will fade over time.

Bucking the trend

In most other areas, the overriding impression is of homework well done, cultural change well managed and financials under control (see "Wooing and Doing" sidebar). The only fly in the ointment has been a big post-merger slump in Baycorp Advantage's share price. In New Zealand, as Unlimited went to press, its share price is 37.7% down on its 12-month high. On the Australian Stock Exchange it's almost halved.

The typical life of a merger sees a surge in valuation when the merger is first announced, because no one understands the costs and investors tend to believe the rhetoric about synergy savings and the benefits of size, says David Parmenter, chief executive of performance measurement company Waymark Solutions. A year or so later, when people realise the financial predictions are not being realised, the share price falls, he says. Just after the merger, AOL Time Warner's share price peaked at around $US70. As the bad financial news trickled in, the share price drifted down and is now trading just under $US20.

The sell-off

But why the share price slump in Baycorp's case? Partly it's a result of the company's past success. Traditionally, Baycorp was a New Zealand share market darling, trading on a price/earnings (p/e) ratio of over 40 - well above the market norm. It reflected investors' expectations of high growth and confidence in management.

The merged company started out with a p/e multiple (reached by dividing the market value per share by earnings per share) of over 30.

Post-Enron, the Australian share market in particular has sold down companies with high p/e multiples.

"Baycorp was what is known as 'priced for perfection' - every bit of good news was factored in to its premium rating. Those sorts of companies are vulnerable to any bit of bad news and they are the first stock sold when the market goes down," says Fisher Funds managing director Carmel Fisher. With one of her funds holding 3% in Baycorp Advantage, Fisher has been buying more shares at the current low prices, punting on a pick-up within two years.

Others have been selling. There was an unusually high level of overlap of the companies' Australasian investors - up to 40% of shareholders held stock in both. Many of these largely institutional investors then found themselves overweight in the merged company and sold down.

Analysts point to the threat of competition as another cause for the share price slide. Rumours of potential competitors threatening Baycorp's dominance have been doing the rounds since last year. Last month Dun & Bradstreet, which has the world's largest corporate database, confirmed it will be entering the Australian consumer credit reporting market in Australia.

That market in Australia accounts for 17% of Baycorp Advantage's total revenue but it sees no reason to panic. Grant Samuel's independent report on the merger said some of the major overseas credit bureaus had closely looked at entering the Australian market. But if they do so, it will not be as a result of the merger itself, the report says, as that has not caused any direct change in the competitive environment in either country. In other words, it would have happened anyway, and the merged company is better placed to withstand new competition.

One Australian analyst says, "The market used to think these two companies were impenetrable, but that perception has changed to some degree." However, UBS Warburg analyst David Roberton says it would be a long and costly process for a competitor to replicate Baycorp Advantage's credit reporting database and win over its diverse customer base.

"Let's put the competition in perspective. The reality is it is a difficult industry to access, other than in niche areas. Someone may be successful in picking up good business in niche areas that won't take anything away from the existing business Baycorp has." Roberton thinks the merged company still justifies high multiples because of its growth opportunities and values it at $A6.10 per share - well above the current market value.

Baycorp Advantage is building barriers to entry through adding increased value to credit checks, diversifying its revenue base and cutting costs, says Salomon Smith Barney analyst Ed Prendergast in a report in late March. "While the chances of any competition severely impacting Baycorp's returns are assessed to be fairly low, there is the chance that major customers will use any proposal as a point of leverage to push for lower prices from Baycorp Advantage. Given the high fixed cost nature of the business, this could have an exaggerated impact on operating earnings," he says. "This stresses the imperative on Baycorp to grow new revenue areas, diversify its customer base and cut operational costs - all of which are underway."

The bottom line

McLaughlin is one of those blokes with a firm handshake that looks you straight in the eye - a traditional Kiwi straight shooter. While polite, he gives the impression he'd rather be out doing business than talking about what needs to be done. He claims to be fairly relaxed about the share price volatility, saying the fundamentals of the business remain unchanged. But mergers are tricky to manage and the company really has to justify its premium rating again.

Analysts say it will be the first half of 2003 before good earnings growth will really show through. Baycorp Advantage has to write off $A407 million in goodwill on the books because of the merger, even though the value of its business may be growing. This will impact the bottom-line to the tune of $A25 million per year. McLaughlin says most investors look to earnings - the EBITDA figure - anyway.

For investors who've hung in there in recent months, it all comes down to McLaughlin delivering the promised synergy benefits on time. He says there will be no compromise on achieving that. In fact, today he's more confident of reaching the target than he was at first. "Since we first looked at the benefits … we've written a project plan around those and taken them a lot further. It now looks very deliverable."

Past experience at Baycorp tells him if he delivers the goods, the share price will follow. Shareholders will be hoping so.

Wooing and doing

Ten ways Baycorp and Data Advantage produced a workable merger

Suck it and see: Long before they actually merged, Baycorp and Data Advantage set up a 50/50 receivables management joint venture in Australia. The joint venture company, Alliance, was established in 1999 and appointed sole provider of out-sourced debt management services for the Commonwealth Bank of Australia in June 2000. The bank then took a one-third shareholding in the joint venture.

"A lot of companies attempt to go into a new market with a new product and it frequently ends in disaster. We chose to move one step at a time taking our traditional business into a new market by forming a joint venture company with a long-established player in the marketplace. We looked at others but knew our only dancing partner would be Data Advantage," says chair Roseanne Meo. (She recently agreed to stay on as Baycorp Advantage chair for another six months, after initially saying she would step down to deputy by the first quarter of this year.)

Learn from past mistakes: Baycorp was determined to avoid the disaster of its earlier foray into Australia in the 1980s. This time, it took a 9.9% stake in Data Advantage for $A45.6 million "to get their attention", Meo says. Soon after, "marriage" negotiations began in earnest.

Both parties wanted a friendly merger rather than hostile takeover. But the protracted negotiations broke off at one stage, apparently over valuation issues. Data Advantage chairman Brian Gatfield went public with a letter saying he was frustrated at being unable to reach agreement on a merger ratio based around market prices.

Like most lovers' tiffs it was eventually resolved behind closed doors.

Meo says she knew the merger would happen eventually and it was important not to flinch at that crucial stage. "Shareholders wanted it, customers wanted it and it was economically rational. I never had any doubt that it would happen, rather how it would happen."

Take time: Merger failures are usually blamed on "cultural conflict" and "poor communication". However, a study last year by the US-based IABC Research Foundation found often they fail, despite the best communication efforts, because the level of projected synergy was over-estimated or they were done for the wrong reasons, such as management ego.

"The existing research serves as a warning to those executives who pride themselves in making a quick deal, yet do not spend enough time on due diligence, strategically planning the implementation process or assessing the true synergies of the merged entity," the study says.

That's not something you can accuse Baycorp's Keith McLaughlin and the board of doing. If anything, McLaughlin says the merger negotiations took too long, stretched out over 18 months.

Haggle hard: A sub-committee of both the Data Advantage and Baycorp boards handled all the negotiations, freeing up senior executives to focus on day-to-day business. This also made it easier for the executives to integrate post-merger, without a history of hard bargaining getting in the way.

The board sub-committee also haggled to an unusually high degree, sorting out every detail of the merger before the deal was signed. It decided such things as basing the head office in Australia, who the senior management team would be and where the primary listing would be. "It was better to tackle the details and keep plugging away at it, than rush and hope some of the issues were not going to emerge during the merger process," Meo says.

Put integration first: Research by international consultancy PA Consulting shows that if there is not a detailed plan of how the benefits are going to be delivered within 100 days of signing the deal, you will never get them. And if the bulk of that activity is not implemented in the first year, the merger will not produce the expected benefits. In fact, PA Consulting's research suggests that if integration is delayed for a year, the merged company must return an extra 18% in benefits to recoup the acquisition premium.

Baycorp and Data Advantage set up an integration team (now dismantled) comprised of senior executives from both companies well before the December merger date. The board opted to involve just the people responsible for delivering the results and so external advisers were left out. It also helped the executives get to know one another in a short time. Quick solutions, including saving $1 million in corporate costs, have already been implemented.

Ensure a snug fit: Perhaps the most important reason for the merger's success, McLaughlin says, was that the rationale made such sense. Baycorp and Data Advantage were a good fit. The Kiwi company had a well-developed technology platform in debt collection and credit information services. The Sydney company was a leading supplier of credit bureau services and had developed several software products, including credit risk management solutions and fraud detection. It was well established in the larger, less mature Australian market while Baycorp needed to expand its borders after dominating the New Zealand market. The telecomms and banks that are the group's biggest customers are all Australasian, and all wanted a seamless transtasman service. Where the two companies had previously competed in Southeast Asia, the combined entity has a stronger offering to the market.

There was little skills overlap. The merged company has already introduced Data Advantage's risk-based scoring into New Zealand, which helps companies evaluate an individual's credit history to better predict how they're going to pay in future.

Merger of equals: It was a merger of equals rather than one acquiring another. After hardball negotiations, the deal was done at market value, with Baycorp shareholders getting 1.56 Data Advantage shares for every one of their shares. This gave Baycorp shareholders 58% of the merged company and Data Advantage shareholders 42%. It meant the Data Advantage shareholders contributed a greater share of the earnings (particularly forecast earnings) than the share of the merged company they received. But the Grant Samuel report found the deal was fair to both parties overall, and the potential gains higher than if the merger was delayed or never consummated.

Cultural clash: Where merging companies often fail is in focusing integration efforts on formal systems and processes, forgetting to bring culture into the equation. But after all, merging two companies is essentially a merging of people. All the best laid plans and marketing tactics fall apart if the people can't work together.

The cultural fit between Baycorp and Data Advantage is better than anticipated, says former Data Advantage chief executive David Grafton, now Baycorp Advantage executive director. "People have really jettisoned the Kiwi/Aussie baggage," says the Englishman. What Baycorp Advantage did was deliberately set out to form a new company. It used an extensive process to identify the best parts of the culture of both companies and take them forward into the new one, leaving behind what hadn't worked so well.

Marriage guidance: It is also important to remember the impact a merger has upon employees. As former GE boss Jack Welch stated in Fortune magazine some years ago, "Having the company you work for acquired is probably the worst thing that can happen to somebody, other than the loss of a family member … All the things you have learned, all the truths you have known, your boss, where you get your pay-cheque from, your security, change all in one day." Companies, particularly in the US, are even employing psychologists to apply marriage guidance tricks to mergers and acquisitions. Not here; in Baycorp Advantage's case the company actually increased its New Zealand workforce by 10% post-merger.

Top people power: Among its top reasons for under-performing mergers, Price Pritchett's book After the Merger: Managing the Shockwaves suggested that management talent in the acquired firm is often not as strong as expected and key talent leaves the company. Of Baycorp Advantage's top management team, only Data Advantage's chief financial officer John Martin left at the time of the merger and two senior executives were made redundant. Baycorp says Martin indicated early on in the negotiations he would leave. His replacement, Tim Wilson, came from outside.

Roseanne Meo says the biggest merger concern was retaining top management - in particular the two chief executives. It is an unusual situation for one of the former bosses, in this case David Grafton, to accept a subsidiary role after not getting the top job. Grafton says having the two chief executives remain in the business and get on so well has sent a powerful message to customers and staff. "One of the important things for me was to put ego issues to one side and look at what is best for the business going forward and what I can do."

Grafton has particular responsibility for value-added services and international expansion, which he thinks will be the big driver of Baycorp Advantage's future long-term growth. The Asian strategy is "no get-rich-quick scheme" though, he warns. Earnings growth will be driven from the Australasian businesses in the next few years.

Rather than doubling up, the two senior executives are seen to have complementary skills and are both rated highly. McLaughlin is respected as being a good manager with entrepreneurial flair. Grafton has had wide international experience with global players. He says the business benefits by having someone with his skills focused on long-term strategy, allowing the chief executive to fully concentrate on the day-to-day business and short-term goals.

In brief

  • Keep it friendly. The history of hostile mergers is littered with failures

  • Let the board handle negotiations, rather than senior executives who are less detached and get distracted from the day-to-day business

  • Does the merger make strategic sense for customers and staff? Are the two companies really complementary?

  • Set up a joint venture company if possible, to test the waters

  • Sort out the merger detail right down to the nitty-gritty before sign-off

  • Make sure both parties get a fair deal or there will be on-going resentment

  • Don't forget your people. Staff need to be informed and happy with the cultural fit of the new company. Don't play politics or have hidden agendas

  • Set up an integration team responsible for making sure what has been planned actually happens on time

  • Try to retain as many of the senior management team as possible

  • Take the best bits of both companies and move forward, rebranded as a new company

Fiona Rotherham

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